Exchange Rate Policy in China after the Financial Crisis: Evidence from Time‐varying Exchange Rate Basket

• Published date: 01 August 2015
• Date: 01 August 2015
• DOI: http://doi.org/10.1111/rode.12161

Exchange Rate Policy in China after the Financial

Crisis: Evidence from Time-varying Exchange

Rate Basket

Jarko Fidrmuc and Martin Siddiqui*

Abstract

We analyze the period of a managed floating exchange rate policy in China between June 2010 and Novem-

ber 2014. We estimate a time-varying structure of a hypothetical currency basket using the Kalman filter.

We show that the exchange rate policy continues to focus on the US dollar. However, its weight has been

gradually declining, while this decline has moderated in 2014. The euro played some role before summer

2011, but became negligible after the outbreak of the European sovereign debt crisis. Finally, the Thai baht

has positive implicit weights.

1. Introduction

The World Bank expects China to become a high-income economy as well as the

world’s largest economy before 2030 (World Bank, 2013). After the Chinese admin-

istration introduced unprecedented reforms in 1980s, today nearly a quarter of the

population lives in cities with an income per capita which resembles that of certain

OECD countries. In particular, gross domestic product (GDP) per capita in purchas-

ing power parity (PPP) in China’s richest 25 metropolitan areas is on average equiva-

lent to Portugal’s value (OECD, 2013). Not surprisingly, growth in the world’s most

populous country has changed the distribution of economic activities across the

world. According to International Monetary Fund (IMF) data, the share of Chinese

GDP in the world economy, valued at purchasing-power-adjusted prices, nearly

doubled from 7.5% in 2001 to 14.3% in 2011. This remarkable economic develop-

ment is accompanied by financial sector reforms and growing competition among

domestic companies.

In contrast to the majority of central banks in advanced economies, the People’s

Bank of China (PBC) does not only use standard instruments of monetary policy.

The use of multiple instruments is aimed at supporting the PBC’s monetary

policy, which pursues multiple objectives—price stability, economic growth and

* Siddiqui: Zeppelin University Friedrichshafen, Chair of International Economics, Am Seemooser Horn

20, Friedrichshafen 88045, Germany. Tel: +49-(0)7541-6009-1243. E-mail: martin.siddiqui@zu.de;

martin.siddiqui@googlemail.com. Fidrmuc: Zeppelin University Friedrichshafen, Am Seemooser Horn 20,

Friedrichshafen 88045, Germany; Institute of East and Southeast European Studies (IOS), Regensburg,

Germany; IES, Charles University in Prague, Prague Czech Republic; School of Economics, Henan Uni-

versity, Kaifeng, China. The authors would like to thank Iikka Korhonen, Linlin Niu, and the participants

of the Asian Meeting of the Econometric Society 2013 in Singapore, China Meeting of the Econometric

Society in Xiamen in 2014, and the conference on “Exchange Rates, Monetary Policy and Financial Stabil-

ity in Emerging Markets and Developing Countries” in Leipzig, October 2014, for helpful comments and

discussions. The usual disclaimer applies.

Review of Development Economics, 19(3), 608–623, 2015

DOI:10.1111/rode.12161

© 2015 John Wiley & Sons Ltd

exchange rate stability (Sun, 2013). The objective of exchange rate stability led to

observers of the Chinese exchange rate regime witnessing several back-and-forth

changes, accompanied by minor adjustments, between 1996 and 2014. Those

changes mainly consisted of two different regimes—namely, a currency peg against

the US dollar and a peg against a basket of currencies with secret weights. Because

of its opaque composition, the latter is of main interest. The actual composition of

the basket of currencies is relevant for economists in order to gain a better under-

standing of the Chinese exchange rate management, but for policy makers and busi-

ness as well. In addition, for economists, the actual composition of the basket of

currencies relates to many discussions beyond exchange rate regimes, such as global

imbalances and international trade competitiveness, to name the most important

ones.

Compared with the first period of a managed floating exchange rate regime,

the second period has received surprisingly little academic attention so far.

However, analyzing this second period of a managed floating exchange rate regime

allows one to identify changes in the Chinese exchange rate management in the

aftermath of the financial crisis, by comparing findings with those obtained from the

first period of a managed floating exchange rate regime. Another observation moti-

vating an assessment of the current regime is the gradual widening of the floating

bands of the renminbi against the US dollar, which implies a more market-oriented

exchange rate and is mirrored in the halt of accumulation of foreign exchange

reserves1by the PBC in 2012 (OECD, 2013). The first period of managed floating

regime was characterized by a remaining de facto peg against the US dollar, allow-

ing for less appreciation than expected. It is important to note that expectations

regarding the current regime seem to have adjusted. Most recently, the difference

between the spot rate of the renminbi against the US dollar and the corresponding

12 months non-deliverable forwards is rather negligible, whereas it achieved consid-

erable values during the first period of managed floating from 2005 to 2008 (see

Figure 1a).

To our best knowledge, there are only very few treatments of the second floating

exchange rate regime period so far. We aim to fill this gap in the literature. We apply

the methodology proposed by Fidrmuc (2010) and estimate the weights of selected

international currencies for the renminbi exchange rate management. We show that

the second and most recent period of exchange rate reforms shows some similarities

to the first, but also many differences. First, we confirm the dominance of the US

dollar also during this second period of managed floating. Second, we observe a

declining weight attached to the US dollar between 2010 and 2014, while the decline

of the US dollar weight moderated after a short-lived increase in 2014. Furthermore,

deviations from the gradual decline of the weight attached to the US dollar coincide

with major political and economic events in the United States. Third, we observe

slight evidence that the euro was used as an exchange rate target at the beginning of

the second period of managed floating, but its weight approached zero after the deep-

ening of the debt crisis in the European Monetary Union. Finally, the Thai baht

gained importance compared with the first period of managed floating (Fidrmuc,

2010).

Hence, this study contributes to the discussion regarding China’s managed floating

exchange rate regime and sheds some light on the most recent composition of the

secret basket of currencies used by the PBC. It contributes to our understanding of

how far China’s exchange rate policy has changed in the aftermath of the latest policy

announcements and the financial crisis.

EXCHANGE RATE POLICY IN CHINA 609

© 2015 John Wiley & Sons Ltd